Top up RRSPs with investment loans

With the March 2 RRSP deadline quickly approaching, it’s likely some Canadians are trying to find a way to maximize their 2008 contribution. One way to top up the account – and secure a 46% tax credit – is through leveraged investing .

It’s a risky practice, but borrowing to invest in an RRSP is one way investors can get the most out of their registered plan. And with low interest rates, and stock prices that have plummeted 13% on average since the beginning of the year, now might be the best time to take out an investment loan.

“This could make sense for someone if 2008 was a high income year for them and they expect their future income will come down,” says Cynthia Kett , a principal at Toronto-based financial planning firm Stewart & Kett. “That allows them to maximize the tax savings and shelter the high income.”

Jamie Golombek , managing director of tax and estate planning at CIBC Private Wealth Management, agrees that in certain situations this strategy could work. He points out that leveraged investing and RRSPs go hand in hand only in a short-term situation for someone in a high tax bracket.

“If they’re able to pay off that loan in a short period of time, while the money is in the RRSP for many years and growing at a tax deferred basis, it can be a good strategy,” he says. “But it’s very short-lived. Say someone was in a high tax bracket for 2008 and their income in 2009 would be lower because they lost their job. They could use the loan to generate a 46% tax refund. If they could pay off that loan in a short period of time it could provide an enormous benefit to someone.”

It’s important for investors to know that the interest on this type of loan is not deductible like it is when used in non-registered accounts, so there’s no extra tax benefit.

The biggest risk with leveraged investing is that the value of an investment could continue to slide and your loan will suddenly become extremely difficult to pay back.

“It’s all well and good if everything goes up,” says Kett. “If you borrow $100,000 at 3% to invest for a year and it increases by 20%, you make $20,000 in gains and pay $3,000 in interest, for a net of $17,000 or a 17% return. If it goes down 20%, you’ll have 23% net negative return so you have to make 25% just to get back to starting point. Sometimes people forget to think about that part of it.”

“With any leveraged investing, you have to look at the markets now,” adds Golombek. “They’re down, but it doesn’t mean they can’t go lower. If someone would have told me a year ago to take out an RSP loan, my loan would still be outstanding and my RRSP could be down 45%. Was that a good strategy a year ago? It depends on the risk tolerance of the investor.”

While the market uncertainty should be a deciding factor whether or not someone tops up their RRSP with borrowed cash, ultimately it comes down to rate of return. Can an investor earn a return greater than the cost of borrowing?

“It’s hard to say,” says Kett. “If prime is 3%, can we be reasonably certain of achieving more? Historically, market gains have been made one to two years following a decline. But, is it different this time? With this downturn being global, it might be.”